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May 24, 2008

It Appears That I Should Have Dug Deeper into Lehman!
by Reggie Middleton

I never got a chance to perform a full forensic analysis of Lehman, but did put a fair size short on them a few months back due to their "smoke and mirrors" PR (oops), I mean financial reporting. There were just too many inconsistencies, and too much exposure. I was familiar with the game that some I banks play, for I did get a chance to do a deep dive on Morgan Stanley, and did not like what I found. As usual, I am significantly short those companies that I issue negative reports on, MS and LEH included. I urge all who have an economic interest in these companies to read through the PDF's below and my MS updated report linked later on in this post. In January, it was worth reviewing "Is this the Breaking of the Bear?", for just two months later we all know what happened.

I came across this speech by David Eihorn and he has clearly delineated not only all of the financial shenanigans that I mentioned in my blog, but a few more as well. Very well articulated and researched.

Here are a few choice excerpts:

"The issue of the proper use of fair value accounting isn't about strict versus permissive accounting. The issue is that some entities have made investments that they believed would generate smooth returns. Some of these entities, like Allied, promised investors smoother earnings than the investments could deliver. The cycle has exposed the investments to be more volatile and in many cases less valuable than they thought. The decline in current market values has forced these institutions to make a tough decision. Do they follow the rules, take the write-downs and suffer the consequences whatever they may be? Or worse, do they take the view that they can't really value the investments in order to avoid writing them down? Or, even worse, do they claim to follow the accounting rules, but simply lie about the values?

The turn of the cycle has created some tough choices. Warren Buffett has said, "You don't know who is swimming naked until the tide goes out." I do not believe the accounting is the problem. The creation of FAS 157 and other fair value measures has improved disclosure, including the disclosure of Level 3 assets - those valued based upon non-observable - and in many cases subjective - inputs. This has helped investors better understand the financial positions of many companies. For entities that are not over-levered and have not promised smoother results than they can deliver, when the assets have fallen in market value, they can take the pain and mark them down. It doesn't force them to sell in a "fire-sale." If the market proves to have been wrong, the loss can be reversed when market values improve. For levered players, the effect of reducing values to actual market levels is that the pain is more extreme and the incentive to fudge is greater. With this in mind, I'd like to review Lehman Brothers' last quarter. Presently, Greenlight is short Lehman. Lehman was due to report its quarter two days after JP Morgan and the Fed bailed out Bear Stearns. At the time, there were a lot of concerns about Lehman, as demonstrated by its almost 20% stock price decline the previous day with more than 40% of its shares changing hands. In the quarter, bond risk spreads had widened considerably and equity values had fallen sharply. Lehman held a large and very levered portfolio.

With that as the background, Lehman announced a $489 million profit in the quarter. On the conference call that day, Lehman CFO Erin Callan used the word "great" 14 times, "challenging" 6 times; "strong" 24 times, and "tough" once. She used the word "incredibly" 8 times. I would use "incredible" in a different way to describe the report. The Wall Street Journal reported that she received high fives on the Lehman trading floor when she finished her presentation.

Twenty-two days after the conference call, Lehman filed its 10-Q for the quarter. In the intervening time, I had made a speech at the Grant's Spring Investment Conference where I observed that Lehman did not seem to have large exposure to CDOs. This was true inasmuch as Lehman had not disclosed significant CDO exposure.

Let's look at the Lehman earnings press release (Table 1). Focus on the line "other asset backed-securities." You can see from the table that Lehman took a $200 million gross write-down and has $6.5 billion of exposure...

... Now let's look at the footnote 1 of the table, explaining Other asset-backed securities:

The Company purchases interests in and enters into derivatives with collateralized debt obligation securitization entities ("CDOs"). The CDOs to which the Company has exposure are primarily structured and underwritten by third parties. The collateralized asset or lending obligations held by the CDOs are generally related to franchise lending, small business finance lending, or consumer lending. Approximately 25% of the positions held at February 29, 2008 and November 30, 2007 were rated BB+ or lower (or equivalent ratings) by recognized credit rating agencies...

Last week, Lehman's CFO and corporate controller confirmed that the whole $6.5 billion consisted of CDOs or synthetic CDOs. Ms. Callan also confirmed that the 10-Q presentation was the first time that Lehman had disclosed the existence of this CDO exposure. This is after Wall Street spent the last half year asking, "Who has CDOs?" Incidentally, I haven't seen any Wall Street analysts or the media discuss this new disclosure.

I asked them how they could justify only a $200 million write-down on any $6.5 billion pool of CDOs that included $1.6 billion of below investment grade pieces. Even though there are no residential mortgages in these CDOs, market prices of comparable structured products fell much further in the quarter. Ms. Callan said she understood my point and would have to get back to me. In a follow-up e-mail, Ms. Callan declined to provide an explanation for the modest write-down and instead stated that based on current price action, Lehman "would expect to recognize further losses" in the second quarter. Why wasn't there a bigger mark in the first quarter?

Now, I'd like to put up Lehman's table of Level 3 assets (Table 3). I want you to look at the column to the far right while I read to you what Ms. Callan said about this during the Q&A on the earnings conference call on March 17.

[A]t the end of the year, we were about 38.8 [billion] in total Level 3 assets. In terms of what happened in Level 3 asset changes this quarter, we had net sort of payments, purchases, or sales of 1.8 billion. We had net transfers in of 1.1 billion. So stuff that was really moved in or recharacterized from Level 2. And then there was about 875 million of write-downs. So that gives you a balance of 38,682 as of February 29.

As you can see, the table in the 10-Q does not match the conference call. There is no reasonable explanation as to how the numbers could move like this between the conference call and the 10-Q. The values should be the same. If there was an accounting error, I don't see how Lehman avoided filing an 8-K announcing the mistake. Notably, the 10-Q changes somehow did not affect the income statement, as there must have been other offsetting adjustments somewhere in the financials....

... When I asked them about this, Lehman said that between the conference call and the 10-Q they did a detailed analysis and found, "the facts were a little different."

I want to concentrate on the $228 million of realized and unrealized gains Lehman recognized in the quarter on its Level 3 assets. There is a $1.1 billion discrepancy between what Ms. Callan said on the conference call - an $875 million loss - and the table in the 10-Q, which shows a $228 million gain.

I asked Lehman, "My point blank question is: Did you write-up the Level 3 assets by over a billion dollars sometime between the press release and the filing of the 10-Q?" They responded, "No, absolutely not!"

However, they could not provide another plausible explanation. Instead, they said they would review the piece of paper Ms. Callan used on the call and compare it to the 10-Q and get back to me. In a follow-up e-mail, Lehman offers that the movement between the conference call and the 10-Q is "typical" and the change reflects "re-categorization of certain assets between Level 2 and Level 3." I don't understand how such transfers could have created over a $1.1 billion swing in gains and losses...

I would like to add that Morgan Stanley is guilty of much of what Lehman is being accused of, and with much more net counterparty exposure and leverage to boot. See The Riskiest Bank on the Street and particularly Reggie Middleton on the Street's Riskiest Bank - Update. I would like to excerpt page 4 of that report here to see how similar the marketing (er, sorry about that again), I mean "financial reporting" of these two companies are:

Worsening credit market to impact Morgan Stanley's financial position

The current gridlock in the credit market has drastically pulled down the mark-to-market valuation of mortgage-backed structured finance products, resulting in significant asset write-downs of banks and financial institutions. It is estimated that further write-downs by investment banks could touch $75 bn in 2008 after an estimated $230 bn already written off since the start of 2007. With the situation not expected to improve in the near-to-medium term, investment banks are likely to face a sizeable erosion of their equity from large write-downs in the coming periods. Though the recent mark-down revelations by UBS and Deutsche Bank have injected some positive sentiment in the global capital markets with the hope that the credit crisis has reached an inflection point, it is overly optimistic to believe that the beginning of the end of the current turmoil is at hand before the causes of the turmoil, tumbling real asset prices and spiking credit defaults, cease to act as catalysts.

* expected

Morgan Stanley wrote off a significant $9.4 bn of its assets in 4Q2007. However, the write down in 1Q2008 was much lower with $1.2 bn mortgage related write-down and $1.1 bn leveraged loan write-down, partly offset by $0.80 bn gains from credit widening under FAS159 adjustments. One of the factors which the bank considers while estimating asset write-downs is the movement in the ABX index which tracks different tranches of CDS based on subprime backed securities. Nearly all tranches of ABX index have witnessed a significant decline over the last six months. While Morgan Stanley's 4Q2007 write-down of $9.4 bn appeared in line with a considerable fall in the ABX index during the quarter, a similar nexus is not evident for 1Q2008. Morgan Stanley recorded a gross write-down of $2.3 bn in 1Q2008 though the decline in ABX indices seemed relatively severe (however not as steep as in the preceding quarter). The disparity raises a concern that Morgan Stanley might report more losses in the coming periods.

ABX BBB indices (September 26, 2007, to April 2, 2008) Source: Markit.com Although the ABX indices showed a slight recovery in March 2008, this is expected to be a temporary turnaround before the indices resume their downward movement owing to expected continuing deterioration in the US housing sector and mortgage markets. The following is a detailed, yet not exhaustive, example of Morgan Stanley's "hedged" ABS portfolio - Morgan Stanley ABS Inventory (1.65 MB).

"Hedged" is a parenthetical because we believe that large scale investment bank hedges are far from perfect. We discuss this later on in the report.

These research reports were initially done in January and April, and I never got the chance to publicly release my thoughts on this hedging billions of dollars of specific risks with broad mathematical indices, marginal (at best) counterparties, and potentially litigous swap agreements, and such. Unfortunately, it looks like other investors/analysts may have beat me to the punch. Just remember, you heard it here first!

The US housing markets are yet to stabilize and housing prices are still way above their long-term historical median levels, leaving scope for a further downside in prices. Between October 2007 and January 2008, the S&P Case Shiller index declined nearly 6.5% (with 2.3% decline in January 2008 alone). We would like to make it clear that although the CS index is an econometric marvel, it does not remotely capture the entire universe of depreciating housing assets. It purposely excludes those sectors of the housing market that are hardest hit by declines, namely: new construction (ex. home builder finished inventory), condos and co-ops, investor properties and "flips", multi-family properties, and portable homes (ex. trailers). Investor properties and condos lead the way in defaults due to excess speculation while new construction faces the largest discounts, second only to possibly repossessed homes such as REOs. A decline in this expanded definition of housing stock's pricing could result in increased defaults and delinquencies, significantly beyond that which is represented by the Case Shiller index, which itself portends dire consequences. As credit spreads continue to widen over the next few quarters, the assets would need to be devalued in line with risk re-pricing. Morgan Stanley and the financial sector in general, are expected to continue with their balance sheet cleansing exercise, recording further asset write-downs till stability is restored in the financial markets. While it is believe the expected continuing fall in the security market values would indicate more write-downs in the coming quarters, a part of this could be set-off under FAS159 by implied gains from write-down of financial liabilities off an expected widening of credit spreads. Morgan Stanley is expected to record assets write-down losses of $16.5 bn and $7.6 bn in 2008 and 2009, respectively, considering the bank's increasing proportion of level 3 assets amid falling security values. This would be partially off-set by FAS159 gains of $930.8 mn and$116.1 mn in the two years off revaluation of its financial liabilities. It is important to note the fact that FAS 159 gains are primarily accounting gains, and not economic gains and they do not truly reflect the economic condition of Morgan Stanley. Of the $18.3 bn of total liabilities for which the bank makes adjustments relating to FAS159, $14.2 bn and $3.1 bn of liabilities relate to long-term borrowings and deposits.

Since most of these securities are traded in the secondary market, it would be difficult for Morgan Stanley to translate these accounting gains into economic gains by purchasing them at a discount to par during a widening credit spreads scenario. To explain in simpler terms, marketable securities can be purchased at a discount to par if credit spreads increase as MS debt is devalued. Thus, theoretically, MS can retire this debt for less than par by purchasing this debt outright in the market, and FAS 159 allows MS to take this spread between market values and par as an accounting profit, presumably to match and offset the logic in forcing companies to market assets to market via FAS 157. In reality, only marketable securities can yield such results in an economic fashion, though companies that would be stressed enough to experience such spreads probably would not be in the condition to retire debt. In Morgan Stanley's case, these spreads represent non-marketable debt such as bank loans, negotiated borrowings and deposits. These cannot be purchased at less than par by the borrower, thus any accounting gain had through FAS 159 will lead to phantom economic gains that don't exist in reality. For instance, a $1 billion bank loan will always be a loan for the same principle amount, regardless of MS's credit spreads, unless the bank itself decides to forgive principal, which is highly unlikely. It should be noted that Lehman Brothers actually experienced an economic loss for the latest quarter of about $100 million, but benefitted by the accounting gain stemming from FAS 159, that led to an accounting profit of approximately $500 million. This profit, which sparked a broker rally, was purely accounting fiction. Similarly, Morgan Stanley (in economic profit, ex. "real" terms) overstated its Q1 '08 profit by approximately 50%. This overstatement apparently induced a similarly rally for the brokers. Quite frankly, we feel the industry as a whole is in a precarious predicament due to dwindling value drivers, a cyclical industry downturn, a credit crisis and a deluge of overvalued, unmarketable and quickly depreciating assets stuck on their balance sheets. Their true economic performance is revealing such, but is masked by clever, yet allowable accounting shenanigans.

Reggie Middleton
http://boombustblog.com/

Reggie Middleton is the personification of the freethinking maverick--the penultimate nonconformist as it applies to macro strategies, investment, and analysis. He uses his background and knowledge in new media, distributed computing, risk management, insurance, financial engineering, real estate, corporate valuation, and financial analysis to pursue, analyze, and capitalize on global macroeconomic opportunities.

Finding most available research lacking, both in quality and quantity, Mr. Middleton assembled his own talented research staff. As forensic research is a lynchpin for his own investing, "to actually put food on the table," he stands behind it as doing what it is supposed to do - illustrate, elucidate and educate.

He does not sell advice or research. He is an entrepreneur who exists outside of mainstream corporate America and Wall Street. This allows him the freedom to do things that many cannot--perform without conflicts of interest and corporate politics. He prides himself on developing some of the highest quality, actionable research available - regardless of price. He welcomes any and all to peruse his blog of freely available analysis, opinion and participatory social media; use his custom tools, download files, interact with the community and make critical comparisons from a results orientated perspective. Reggie believes ideas and implementations are improved and fine-tuned when bounced off of the collective intellect of the many, in lieu of that of the few - in essence, a form of collaborative open source financial analysis.

Visit his blog Boom Bust Blog.

Copyright © 2007-2008 Reggie Middleton

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